A Great Man Cometh?

Every once in a great while a larger than life figure comes along who dramatically changes his (or her) country for the better. Ronald Reagan, Margaret Thatcher and Deng Xiaoping are three that come to mind. Narendra Modi, the just elected future Prime Minister of India, has this potential for greatness. And yes this has significant investment implications.

Narendra Modi’s Bharatiya Janata Party, aka the BJP, has just won an overwhelming victory in the key election for India’s Lok Sabha, or Lower House. The pro-business Modi is India’s new Prime Minister. Since the BJP won an outright majority, he will not have to form coalitions with other parties that might not share his views. The socialist, welfare state oriented Congress Party, which has ruled India almost continuously since independence in 1948 and which led India’s independence movement, has gone down to an overwhelming defeat. At least at the national level, India is ready for change.

Narendra Modi has been Chief Minister of the Indian state of Gujarat for the last twelve years. His background, as opposed to the aristocratic Nehru-Gandhi family, is the lowly Ghanchi caste (classified as an Otherwise Backward Caste in Indian official lexicon). He spent his early days as a chai wallah (tea stall worker). Modi as Chief Minister of Gujarat is known for two things. His fantastic probusiness economic management of the state and his alleged complicity in, or at least indifference to, the 1982 Gujarat massacre of Moslems in which over 1000 people died.

Regarding the former, just Google the “Vibrant Gujarat” annual conference. Its attendees comprise a who’s who in Indian and global business. At one of these conferences, Anil Ambani, Chairman of India’s $76 billion Reliance Corporation, praised Modi as “king of kings, a leader of leaders.” It’s not unusual for businessmen to suck up to powerful politicians but that statement was so extravagant that Ambani probably meant it. Gujarat has averaged Asian tiger real GDP growth rates of 13.8% in the last decade.

Regarding Modi’s role in the Gujarat massacre, he undoubtably did not cover himself with glory but he has been exonerated of wrongdoing by the Indian legal system. Not good enough for paragons of virtue like the London Economist which never tires of tut tutting about the failures of its old colonial jewel in the Crown and which before the election declared Modi to be unfit to be Prime Minister. At any rate, the magazine has turned more upbeat on Modi since his win. Nevertheless, many intelligent people do legitimately worry about the extreme Hindu right wing Rashtriya Swayamsewak Sangh (RSS) and its influence on Modi. He was after all active in the RSS in his youth. I would discount this worry. In the just concluded elections, the BJP picked up substantial Moslem votes.

I am betting that economic reform will be the primary focus of the Modi Administration and that he will be successful. But the pessimist case is formidable. Indian Prime Ministers typically arrive with great hopes and leave as a great disappointment. The last BJP Administration, which seemed to hold great promise, was voted out of office.

If things don’t work out regarding the economy, the RSS and its ideas could come to dominate a Modi administration and the country could enter a very dark period. And his own BJP party, while in opposition at the national level, has hardly been a paragon of free market virtue. Regarding key populist legislation, the BJP opposition was worse than the Congress. Moreover, Modi will have to contend with India’s 28 state governments which command a great deal of economic authority. Also, the BJP at least at this moment does not have a majority in the Rajya Sabha, or Upper House, although over time this will probably change. But for now the BJP has only 46 seats of the 250 in the Upper House, with Congress holding 68. Finally the Indian business sector can be viewed as a collection of entrenched interest groups, all intent on the preservation of their economic rents, all the “unintended” result of Indian socialism. Indian business will be the beneficiary of a Modi Administration

but their parochial interests will make them uncertain allies. No matter how bad, all government programs in every country create their own constituencies which then turn out to be implacable enemies of change.

Nevertheless, I think this is India’s big chance. Perhaps India’s last chance. The country’s first Prime Minister, Jawaharal Nehru, in his celebrated Independence day speech, talked about India’s “tryst with destiny.” While you couldn’t call post-Independence India a disaster, it seems like so far the country has only had a tryst with mediocrity. Certainly comparisons with China leave India falling short.

Why India?

India is a potential global economic powerhouse that, aside from an occasional fleeting opening as in 1991, has been held captive in a socialist cage since independence in 1947. With India, unlike Russia or Saudi Arabia, as an investor you don’t get natural resources. Rather as with China you potentially get brains and brawn. My prediction is that a Modi victory will unlock at least some of this potential.

First of all there is the potential demographic dividend. India has roughly 1.1 billion people, is only 31% urbanized, and has a much younger population than say China. Its birthrate has been slowly declining but births per woman were still an estimated 2.51 in 2014, comparatively high as compared with China and advanced industrial nations. With a labor market unfettered by labor restrictions, India could take over from China as the world’s source of cheap labor. It’s a simple model. Surplus labor moves from the countryside where it had negative marginal productivity to factory employment in the cities where marginal productivity is positive. The Lewis tipping point, whereby this process comes to an end, is far out in the future for India compared to its now imminent arrival in a more urbanized China. Of course as we all know the Indian labor market is wrapped in chains with government regulations. Vietnam, at least until the recent trouble, has become the cheap labor alternative to replace China. India should be winning that competition.

Second, there is India the knowledge based, entrepreneurial society. Information flows freely in democratic India as compared with authoritarian China. While India can boast of slums that can rival those of Haiti, it also is the home of some of the world’s best technical universities and world class corporations. And its citizens – especially those of its Bania commercial caste -- have shown their entrepreneurial mettle whether it’s running motels in the US or creating new billionaires in India. The English language is the working language of the Indian corporate and university sectors, another plus. Reflecting this intellectual atmosphere, the Indian diaspora around the world is rising to positions of prominence (like the CEO of Microsoft) in the US and Europe. No glass ceilings for Indians that the Chinese diaspora complains about. Unchain this reservoir of talent within India, change the rules so that amassing wealth in India does not mean garnering government derived monopolies to accrue economic rent and India could come to rival China in the next twenty years.

What Needs to Be Done?

The short answer: EVERYTHING.

Economists get all excited because noted University of Chicago professor Raghuram Rajan is now running India’s central bank. Rajan was a great appointment of the previous government and an important asset in helping to maintain the value of the Indian rupee. But central banks essentially are demand side fiddlers, of great interest to economists because central bank activity is easy to model and because central banks need to hire lots of economists. I hope Modi keeps Rajan but, whether he does or not, India’s basic problems are not related to monetary or fiscal policy. Rather they are SUPPLY SIDE in origin (i.e. structural). It’s as if the Indian government since 1947 has set out to strangle what should be a huge and dynamic business sector. Removal of subsidies and restrictions on the real economy will automatically improve the workings of monetary and fiscal policy.

Here is a list of eight things that need immediate attention. The list could easily be a lot longer. Obviously Modi can’t fix everything at once but investors will settle for an enthusiastic start.

01. Reform the country’s unfair, overly bureaucratic, anti-business, anti-foreign investor tax system. Subramanian Swamy, a key Modi economic advisor, has categorized the Indian tax system as tax terrorism (Americans and Europeans might want to borrow this guy!) Retroactive, confiscatory and arbitrary measures are hallmarks of the current Indian tax system.

02. Reform the country’s labor laws. As Vietnam (sadly) goes up in flames, this is a huge opportunity for India. It is pure fantasy to think that, good as it is, India’s world class knowledge economy could trickle down and employ the country’s less educated and less intellectually gifted millions. Indian labor must be freed.

03. Reform the country’s educational system. India has world renowned technical and business educational institutions but at the same time a substantial percentage of Indian children either go to government schools which are grossly inferior (the teachers rarely show up) or don’t go to school at all. And thousands of Indians have to go abroad for higher education. The private sector has a big role to play here and has expanded dramatically in recent years but (no surprise) is throttled by Indian government rules and regulations and prejudices against private education held by public sector socialists. And all kinds of bureaucratic roadblocks are in the way of foreign institutions that wish to open in India. If education is not reformed, the demographic dividend will turn into the demographic nightmare.

04. Start a major infrastructure build out. In the World Economic Forum’s Global Competitiveness Report for 2011-2012, India ranked 89th out of 142 countries for its infrastructure. I believe that infrastructure bottlenecks are a major ultimate cause of the unacceptably high Indian rate of inflation. And infrastructure is an example of how the Indian passion for equality totally has perverted prior legislation. The recently passed Land Acquisition Act (replacing the older Act passed in 1894), which calls for unrealistic “transparency” and compensation for landowners, has virtually brought to a halt acquisition of land for central government infrastructure projects. The rest of Asia is filling up with new superhighways and in the case of China high speed rails while more often than not Indians have to contend with dirt roads.

05. Cut red tape! The so-called License Raj supposedly disappeared under the brief window opening of 1991 but the elimination of unnecessary red tape is still an unfinished and monumental task in India. Red tape discourages foreign and domestic investment as well.

06. Reform the banking system. In 1969 Mrs. Gandhi nationalized India’s banks. In the liberalization spurt of the early 1990s, new private sector banks were authorized, notably ICICI Bank (NYSE-IBN) and HDFC Bank ( NYSE – HDB). But all the Indian banks are forced to buy government bonds and a percentage their assets by government decree have to be invested in favored sectors. The majority State owned banks today have seen rising non-performing loans as the Indian economy has slowed down and loans to state companies have soured. Here Rajan’s continued presence would be a positive.

07. Reform the aviation sector and sell off or close down Air India, the state owned airline. State owned airlines in virtually all countries are financial disasters and choke off economic growth and tourism.

08. Open the borders and promote trade with neighbors Pakistan, Bangladesh and Sri Lanka. Neighbors are always prosperous countries major trading partners as in the case of the US, Canada and Mexico or the European Common Market.

Investing in India

Anticipating a Modi victory, the Bombay Stock Exchange Index in US dollar terms has appreciated some 20.8% percent since the beginning of the year. If you think Modi will turn out to be a big failure like so many other Indian prime ministers, now is the time to sell Indian stocks, not buy. But if you believe as I do that Modi is about to unleash a Reagan/Thatcher/ Deng Xiaoping multiyear reform, then it is still early days. Remember you are not buying for multiple expansion but rather an acceleration of earnings growth.

Like so many things in India, investing in Indian stocks has its unnecessary difficulties. There are only a limited number of Indian ADRs trading in New York and London. Due to certain Indian restrictions on capital flows and share transfers into ADRs which limit arbitrage, the Indian ADRs can sometimes sell at substantial premiums to the underlying shares as traded in India. On the retail side, it is my impression that foreign investing in Indian domestic stocks is virtually impossible. A US investor for example can’t just click on his or her Fidelity or Schwab account and buy domestic Indian shares.

The stocks you want to buy today are related to a possible infrastructure build-out, domestic consumption, tourism and education. Stocks most foreign investors have probably never heard of.

The great global Indian companies like Infosys (NYSE- INFY) or Wipro (NYSE-WIT) will not benefit that much from Indian reforms because their clients are non-Indian and by sheer luck their industry escaped the dead hand of Indian bureaucracy.

I do not recommend specific stocks in this blog but probably the best way for foreign investors with an interest in India, even smaller institutional investors, is to buy ETFs and mutual funds.